Suit Says Fidelity Mismanaged Stable Value Fund

A recently filed lawsuit accuses
Fidelity Management Trust Company of engaging in imprudent investment
strategies for the Fidelity Group Employee Benefit Plan Managed Income
Portfolio Commingled Pool (MIP), a stable value fund offered as an
investment option in some 401(k) plans for which Fidelity was trustee.

According
to the lawsuit, during a specified class period, the MIP had such low
investment returns and high fees that it was an imprudent retirement
plan investment. The poor performance and high fees of the MIP were the
result of the intentional actions and omissions of Fidelity as trustee
of the plans, the suit alleges. Fidelity delegated day-to-day management
of the MIP to its affiliate, Fidelity Management and Research Company,
and the lawsuit accuses Fidelity of failing to continuously monitor and
supervise its affiliate.

In a statement to PLANADVISER, Fidelity
said, “We believe that the claims in this case are without merit and we
intend to defend it vigorously.”

The compliant says that prior to
2009, Fidelity engaged in an imprudent investment strategy for the MIP
that caused substantial losses to the fund and accordingly exposed
itself and the MIP’s “wrap providers” to substantial losses. Faced with a
substantial decline in the MIP’s market value, and with resulting
pressure from the wrap providers—which were exposed to liability in the
event of significant MIP fund withdrawals—Fidelity responded by adopting
an unduly conservative investment strategy that was contrary to the
purposes of stable value fund investing, agreeing to allow the wrap
providers to charge excessive fees, and charging excessive fees for its
own account.

As of October 1, 2009, the MIP held nearly $9.4
billion in assets, but as of September 30, 2014, the MIP held less than
$6.3 billion in assets. This precipitous decline in assets was due
largely to participant withdrawals caused in part by the consistently
poor performance of the MIP, the lawsuit says. Participant withdrawals
totaled $1.1 billion in 2010, $822 million in 2011, $995 million in
2012, $100 million in 2013, and $511 million in 2014.

NEXT: Makeup of a synthetic GIC

According to the compliant, in
addition to its fiduciary breach under the Employee Retirement Income
Security Act (ERISA), Fidelity also attempted to conceal its improperly
conservative investment and excessive fees from investors by solely
reporting to investors an inappropriate “money market” benchmark for the
MIP rather than a proper stable value fund benchmark that made the MIP
returns appear to be competitive.

This combination of poor
performance and high fees caused the MIP at the relevant times to fail
to produce a net investment return sufficient to outpace inflation. The
MIP also performed far worse than the average stable value fund and far
worse than the most relevant benchmarks, the lawsuit alleges.

The
MIP is a synthetic guaranteed investment contract (GIC), which consists
of two principal features, the complaint explains. The first is an
intermediate term bond fund. The investment manager for the stable value
fund invests in a portfolio of intermediate term bonds with an average
duration of approximately three to four years that will provide a
significantly higher interest rate, or yield, than for example the
short-term (average 60 days or less) securities typically held by a
money market fund.

The second principal feature of a stable value
fund is a “wrap contract” issued by an insurance company or other
financial institution that provides a guaranty that investors will
receive the “book value” of their account, the value of their initial
investments plus interest accrued at certain intervals of time that
reflects the performance of the underlying bond fund. The latter element
is referred to as the “crediting rate.”

NEXT: Mismanagement of the fund and excessive fees

Fidelity, pursuant to the Trust
Agreement for the MIP and industry practice, promised to the plans and
their participants that it would manage the underlying intermediate term
bond portfolio in a manner consistent with the objectives of stable
value investing and credit participant accounts using the rate
determined by the formula set forth in the wrap contracts. However, in
an effort to boost the yield of the MIP and thereby garner more
management fees for itself, Fidelity, before the period at issue in the
lawsuit, engaged in an imprudent and ultimately unsuccessful investment
strategy by, among other things, causing large amounts of the MIP’s
assets to be held in various forms of securitized debt. For example, in
2006, asset-backed securities, mortgage-backed securities and
collateralized debt obligations represented nearly 60% of the MIP’s
assets.

Those and other investments declined in value when the
financial crisis struck in 2008, causing the MIP and the plans that
invested in it to suffer damage beginning in 2009 and continuing for
years afterwards. Specifically, in the fiscal year ending 2008, the MIP
experienced a market value loss of about $381 million. This caused the
effective return of the MIP on a market value basis to be close to zero
for that year. By contrast, during that same fiscal year, the stated
benchmark for the MIP earned close to an 8% yield despite the financial
crisis.

The lawsuit contends that competing stable value funds
which were subject to the exact same underlying economic conditions as
the MIP and had the same conservative investment goals earned
substantially higher returns than the MIP during the relevant time
period while at the same time preserving principal, ensuring liquidity,
and providing stable returns.

In addition, the lawsuit says, “At
the same time as Fidelity provided a gratuitous benefit to the Wrap
Providers by reducing risk to the Wrap Providers at the expense of
investors’ yields, it also paradoxically agreed to an increase in the
fees paid to the Wrap Providers. Between 2009 and 2011, Fidelity agreed
to increase the wrap fees for the MIP from 8 basis points to 22 basis
points or more.”